Fed may extend Wall Street lending

ARLINGTON, Virginia Federal Reserve Chairman Ben Bernanke said on Tuesday the U.S. central bank may keep an emergency lending facility for big Wall Street firms open longer than it initially intended, a signal the Fed is fearful of shutting down a vital backstop.

Credit costs have been driven higher and U.S. economic growth also has been hurt by market turmoil, Bernanke said at a forum sponsored by the Federal Deposit Insurance Corp.

"We are currently monitoring developments in financial markets closely and considering several options, including extending the duration of our facilities for primary dealers beyond year-end, should the current unusual and exigent circumstances continue to prevail in dealer funding markets," Bernanke said.

Remarks by Bernanke and Treasury Secretary Henry Paulson, who spoke at the same conference, calmed financial markets, which had been rattled this week by the possibility that government-sponsored mortgage finance providers Fannie Mae and Freddie Mac would be forced to raise substantial new capital.

"The last thing he wants to do is walk away and see a dealer collapse," Anton Schutz, portfolio manager at Mendon Capital Advisors in Rochester, New York, said of Bernanke. "It's all about safety and soundness," he added.

Paulson contributed to market optimism by saying that flatter sales of existing homes in recent months implied some stabilizing in home-buying demand.

STILL UNDER STRAIN

The Fed set up the so-called Primary Dealer Credit Facility, or PDCF, in March as part of its effort to facilitate the purchase of ailing investment bank Bear Stearns by JPMorgan Chase & Co. It said at the time the PDCF would continue for at least six months.

The lending program allows primary dealers -- the biggest firms that deal directly with the Fed -- to borrow directly from the Fed at the discount rate, currently 2.25 percent.

The Fed's action came after weeks of turbulence in financial markets had raised fears a credit crisis stemming from rising mortgage defaults was spiraling out of control.

Borrowing at the primary dealer facility averaged as high as $38 billion a day in March and early April, but eased to $1.7 billion a day in the week ended July 2.

Bernanke said, though, that markets were still strained.

One indicator of banks' willingness to lend to one another, the gap between the three-month London interbank offered rate, or Libor, and three-month overnight index swaps, was at its widest in over two months on Tuesday.

Bernanke said the Fed, working with other regulators at home and abroad, "has redoubled its efforts to strengthen the capital positions, liquidity reserves, and risk-management practices" of financial institutions it supervises.

On Monday, the Fed and the Securities and Exchange Commission reached an agreement on sharing information about banks. But Bernanke noted that was to deal with immediate conditions.

"In the longer term, legislation may be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers," he said.

"Policy interventions in financial markets run the risks of increasing moral hazard," Philadelphia Fed President Charles Plosser said on June 5.

Richmond Fed President Jeffrey Lacker said on Tuesday he does not see a strong danger of market turmoil if the Fed shuts down the facility.

In a speech that contrasted with Bernanke's somber outlook, Lacker said the risks of a severe economic downturn have diminished "substantially" and said it made sense to raise interest rates to combat unacceptably high inflation.

"Just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well," he said.

CAPITAL STANDARDS

Bernanke said that whereas the Securities Exchange Commission now handles oversight of big investment banks under a voluntary agreement with them, in the future it should be made clear that a regulator has power to set standards for capital, liquidity holdings and risk management practices of investment banks.

In remarks acknowledging the need for changes to financial oversight, JPMorgan CEO Jamie Dimon endorsed Paulson's proposal to let the government act as a receiver for a failing investment bank and establish a structure for an orderly liquidation of the institution's assets.

"It's complicated, but we need that option," he said at the FDIC conference. "They're not too big to fail."

Bernanke also backed the idea, which he said would help to counter a market perception that some firms will always be bailed out.

"Despite the complexities of designing a resolution regime for securities firms, I believe it is worth the effort," he said.

Bernanke said the Fed and other regulators were considering changes in how derivatives are processed and were assessing so-called repo markets, where primary dealers and banks can get secured financing from risk-averse investors.

Over time, though, changes may be required in how these markets are used and in how settlement systems that banks use to process transactions within them are operated.

"Given how important robust payment and settlement systems are to financial stability, a strong case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems," Bernanke said.

(Additional reporting by Alister Bull in Washington and Dan Wilchins in New York, Writing by Glenn Somerville and Mark Felsenthal; Editing by Dan Grebler)

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